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Gold Market Glitters Again

The summer is flying now. The gold price and the precious metals miners have started to look poised for a significant rally, as the USd stumbles on the f/x markets.

As a reminder: my shadow gold price (ie. valuation) for gold is roughly $1560, assuming that I am correct to think of the 2yr correction as an interruption to the bull market, rather than the start of a new bear market.

If it is a new bear market the bears may well be right about $800. But, I don’t think it is.

Recall what has been required to end a secular bull market cycle in the past: the abandonment of the inflationary policy as a concession to the disparaged public’s growing objection to its effects (in pre 20th century history, this point – the end of a bull cycle in gold – was marked by a return to specie). And remember, I do NOT mean by this your cyclical “tightening” ploy.

Clearly we haven’t reached the point yet where the general public is blaming the central bank for its problems, or where it is prepared to take the consequences of a full liquidation of the malinvestments supported by the central bank.

Why We Have to End the Fed and Accept Liquidation to End the Golden Bull Market

But does this really have to be the recipe for the end of a bull market cycle in gold?

I would suggest the answer is yes.

The reason is: as we progress from one economic cycle to the next, with each cycle marked by changes in banking policy (i.e. from loosening to tightening and back), malinvestment (misallocated/misdirected capital) accumulates.

It accumulates because the central bank does not allow the imbalances to clear, fully.

In other words, instead of allowing the bubble enterprises and malinvestments that have accumulated –and have attached themselves to the Fed like Remoras on a shark– to be reallocated towards more productive ends (i.e. liquidated), they are bailed out in the erroneous belief that their continued activity is supportive to economic growth. Hence the policy continues to pile up waste – malinvestment, public debts, bureaucracy, monopoly profits – and thereby destroy capital from one economic “recovery” (or boom) to the next. These are the structural imbalances that make the US economy increasingly vulnerable to a stagflationary episode. But it is the policy that pushes us there.

The bull market in gold tends to be a late stage development throughout such a progression, and in my opinion it cannot end until either it has gotten too far ahead of itself or the above types of imbalances are allowed to fully clear.

Only with the discrediting of the policy has it been abandoned historically; and that has been when it coincided with the end of a bull market in gold. In my opinion, we are in the late innings of a cycle that started after the end of the last bull market in 1981, and which will ultimately bring the US dollar to its knees.

[My current forecast for gold prices to reach $3-5k by 2017 remains intact]

But that is a process that takes time, and must raise inflation fears more than it has so far.

If the authorities really wanted to end the bull market in gold, and prevent my target from being reached, all they would need to do is end the Fed. The rest would come down around them. The government would have to shrink; the markets would have a chance to work (to clear the imbalances); and you would get real economic growth and prosperity. This would ultimately be bad for gold prices, and contrasts sharply with today’s greater fool’s recovery.

Only genuine austerity (and repeal of the Fed) can end the bull market in gold!

What Makes it Harder Today

But what’s different this time that makes it more difficult to abandon the Fed is that in addition to the structural problem caused by its policy (noted above), which would have to be liquidated, the US government has amassed a massive debt and entitlement obligation. It is important to note this not just for the obvious reasons, but because this fact did not exist the last time that the US economy faced such a dilemma in the late seventies. Thus, this time around, the government itself faces insolvency.

You’ve heard this song before, but the main economic problem in accumulating such large public debts – besides the obvious waste that implies – is that these levels of debt assume an unrealistic interest rate outlook (based on an artificial interest rate structure), and when the market is forced back up toward its “natural” interest rate regime (and then some, say, on inflation fears) all sorts of problems will surface.

So this time not only do policymakers have to abandon the religion of inflationism guiding their policy moves at every corner, and spout out some laissez faire promises they would never keep anyway, they might also be forced to repudiate the public debt to end the bull market.

This is not new; we’ve always known that postponing dealing with the situation would simply result in a larger problem…greater leviathan…greater imbalances…a greater portion of the economy that is dependent on Fed support. But barring these events or another parabolic spike in gold there is no chance in hell the bull market has truly ended!

You Can’t Kill The Gold Bull with Another Inflationary Boom

The bears are being fooled at the moment by yet another unsustainable boom, created in exactly the same way that the previous one was. I am beside myself that, after all the bad press about banks, anyone can still believe that what they are seeing is a true economic recovery, as if the $4 trillion (+73%) expansion in commercial bank deposit-liabilities (powered by a $2 trillion expansion, or a tripling, of the monetary base) since 2008 – all money that is created out of thin air – could not create precisely just such an illusion. It’s as if the investing public never really understood why they were buying gold in the first place! I’ve seen people sell gold here that have listened to the story for over a decade and hence should be aware of the unsustainable nature of the booms created by the Fed.

Have they forgotten the 2001-02 bust?

Have they forgotten 2008? What on earth do they think has changed from what caused the bull market in gold in the first place? Has central banking fallen out of favor -and I just didn’t get the memo yet? Have governments stopped expanding public debt levels?

What has changed at the Fed or with the fractional reserve banks that will stop them from producing the boom-bust cycle, or from debasing the money of the people of the world?

It’s like they believe the Fed policy has worked.

I’m saddened by how many investors have again been duped by Wall Street’s second-rate explanations of the business cycle, and bullish declarations of an economic recovery. But let me reiterate to my audience that you are not seeing any kind of “true” (i.e. sustainable or lasting) economic growth. You are seeing the part of the cycle where productive capital is actually being destroyed. But this loss is effectively papered over. Nominal GDP has expanded $2.4 trillion since 2008. The US money supply has expanded $4 trillion.

You do the math. Is it real? Only if you believe that creating money increases capital.

But then, that is exactly what it doesn’t do.

That is exactly the fallacy implied in the policy.

And it is impossible to adjust for the true amount of that increase in GDP attributed to real growth simply by estimating and adjusting for average (and manipulated) price increases.

But clearly there is some reason to doubt that the expansion in GDP represents a recovery.

Nevertheless, with regard to gold, the thing is that after such a beating, even if the bears were going to be right and us wrong, we aren’t likely to go straight down from here. The sentiment is just far too bearish to sustain anything on the downside. I really believe the weak hands (the short term traders and fear buyers) are all out.

Outlook: USD is Key; But Expect Transition

Technically, the market looks solid down here, based on the way it has bounced off key levels.

The bounce off the $1170 area at the end of the second quarter was bullish (the gains held in), and the $1270 support saw successful tests at least a few times in subsequent weeks.

I am interested to see how the market will deal with chart resistance between $1375 and $1425 in the short term, as that is where most of the volumes concentrated in the April wipeout.

We are cautiously bullish. If it went through those levels in one fell swoop I’d be surprised.

It might be premature for such a swing, though I can’t deny the thought of it happening.

The main reason I’m so bullish in the short term, however, is sentiment.

My thinking is that gold will steadily grind higher and pop back up above $1650 before winter sets in up here in Canada.

And this does not require a catalyst of any kind.

I think there are several assets that are mispriced here: gold is undervalued below $1560 (as mentioned above); equities are now overvalued relative to gold and real corporate earnings power; the natural rate of interest is likely higher than the one the Fed is targeting; and the USD has in the past year become overvalued again. The markets are already trying to correct all of these mis-pricings.

Our thesis has been for the USD to succumb to a reversal of capital flows from US capital markets to markets overseas as the Fed tries to pass the baton on to the ECB and BOJ; and for the US Treasury market to continue to unravel into a renewed debate over the debt ceiling and on “tapering” rhetoric. And I see the latter both weighing on the USd as much as I see the weak dollar fueling further declines in government bond values. I might add that investors have been complacent on the USD recently.

I see US equity markets continuing to lose luster relative to their overseas typically riskier competition, which is the most proximal source of weakness in the USd today. However, I am expecting things to happen over a transition period – of less than a year – after which the market will have become full out bearish on US assets again (stocks, bonds AND dollars).

In this transition I am expecting inflation fears to gradually return, and for gold prices to grind steadily higher, with the gold stocks dominating the top ranks of equity performers from here on.

I am expecting a boost to money growth in the US as banks loosen the spigots themselves now –due to rising optimism and the initial adjustment to new Basel guidelines behind them –although this hasn’t happened yet, and may not ever happen. Combined with the continued decline in cash hoarding (which the pundits will eventually interpret as an increase in “velocity”) I see this potentially stoking a price revolution that will dwarf the ones experienced in 2007 and in 2010, eventually exacerbating declines in stock and bond values, and, depending on the central bank’s handling of it, might even dwarf what we saw in the 1970’s.

Again, this is where we are headed, not where we already have arrived; and the transition may still take months.

Much has been said about the slight backwardation in short-term gold forward rates (GOFO) recently, but most of it is uninformed. It is not likely to reflect a shortage in the physical market. It only reflects sentiment about the holding of gold as collateral relative to the USD. At the moment it says that the market prefers holding dollars as collateral in periods of up to six months out. That won’t last.

But it could suggest a time frame for our transition period: six months.

It also suggests that sentiment is as bearish as it has been at other turning points.

So I see a market that has to correct its current oversold condition by moving toward equilibrium, i.e. or $1560, plus or minus.

From there I expect some volatility until it gains traction for the next leg of the bull.

As a relevant benchmark, consider that historically, or at least since 2008, our shadow gold price (i.e. our valuation estimate for gold) has gained an average of 10% per year.

Hence from the current level (1560), and based on current monetary policy, that could easily continue into the future. Indeed, 10% per year may sound boring compared to the 18% average annual gain experienced from the trough in 1999 to its peak in 2011; but keep in mind that “10%” is still a double every seven years, and it is better than most assets can promise. What’s more, that is from 1560, which is higher than today’s 1360 level; and there is a good chance that money growth rates going forward will pick up, generally speaking.

Furthermore, the real market is far more volatile and makes its biggest moves in spurts that overshoot; followed by long periods of regressing back toward its more realistic fundamental values, as we have seen this past two years following big gains from 2008-11.

There is no reason why we couldn’t see gold similarly shoot up to $3000, maybe $3500, in three short years (2014-17) instead of seven.

Of course it would suffer a hangover, but that is how markets work when you have Leviathan intervening in the medium of exchange.

It could take us a whole year just to get back up to the $1800 level. But it could easily go parabolic from there then. So my suggestion is not to wait for the sentiment to return before wading back in. The doorway is too narrow.

You will get burned, especially in the equities.

Buy today; while there is still blood in the streets, as the old cliché goes. If they go lower, buy some more. We’re still early in this fight.

[And very very late in the correction.]

In the gold equity space, we continue to like IAMGOLD (IAG), Agnico Eagle (AEM), B2Gold (BTO:TSX), and Golden Star Resources (GSS) for exposure to the mid tier and large cap producers. I will be adding three or four more to this list shortly. In the area of emerging producers, we like Papillon (PIR:ASX) which was just added to Van Eck’s GDXJ ETF, Sabina Gold (SBB:TSX) and Midway Gold (MDW). We will add one or two names to this group by month end also.

Ed Bugos is a mining analyst, investment banking professional, and senior analyst at The Dollar Vigilante (an online guide to surviving the dollar crash), with more than 20 years experience in the investment business advising clients on portfolio and trading strategies.